America, the Liberated

America's economic prospects are as cheery as this little fella. Photo by FPG/Hulton Archive/Getty Images.

It is no secret this expansion is America's slowest since World War II. It is also no secret folks are frustrated with sluggish growth and keen for a boost-never mind the fact GDP growth beat its postwar average in four of the last six quarters. But that doesn't mean America's economy is a problem that needs fixing. Stocks have already proven they can rise fine amid slow growth, and efforts to fix what isn't broken often do more harm than good.

I point this out because some overall very fine minds have weighed in with prescriptions lately. The most recent appeared in a Wall Street Journal op-ed Wednesday:

A Recovery Waiting to Be Liberated
John B. Taylor, The Wall Street Journal

In this piece, Professor Taylor^[i] argues slow growth stems from weak labor force participation and lackluster productivity, and "pro-growth" reforms are necessary to jolt businesses out of their slumber-tax cuts, free trade, deregulation, entitlement reform and an attack on the "debt explosion." Now, depending on your beliefs and opinions, you will probably think this prescription sounds smashing or poisonous-and that's the trouble. Whether the US-or any freewheeling, competitive capitalist economy-needs economic reform is a matter of opinion. It is not a provable fact. Both sides of the debate can always produce evidence to support their claims, but there is never a counterfactual.^[ii]

Might the US benefit from some policy tweaks? Maybe! But maybe not. America is already one of the world's most competitive nations. Any potential improvements would probably be marginal-and improvements only in the eye of the beholder. They would probably also create winners and losers, which can wreak havoc on markets. Prospect Theory tells us that if Uncle Sam takes $100 from you and gives it to your buddy, you'll be way more upset than your pal is happy. That net negativity can create a powerful drag, regardless of whether you believe any change is inherently good or bad for the country overall.

For all the talk of bad policy on both sides of the aisle, the simple truth is America's economic structure today is mostly the same as the system that fostered swift growth in the 1980s and 1990s. Tax rates are a wee bit different-higher in some cases, lower in others. Trade is freer. Regulations are a bit lower in some areas and a bit higher in others. Debt, counted as a massive negative in the article, is actually less of an issue today. It's higher in absolute terms but more affordable-annual debt service costs are down to 7.5% of tax revenue, the lowest since 1973. To the extent you believe debt, taxes, regulations and trade are issues, in sum and on average, they are basically neutral since the mid-1980s. OK, maybe not trade, which is far freer today thanks to NAFTA-a plus.

Plus, it isn't clear the problems identified here-weak productivity growth and labor force participation-are the ticket to faster growth. Decades upon decades of data show growth drives employment, not the other way around. In theory and mathematics, perhaps growth resembles the sum of employment growth plus productivity growth, as described here. But the real world doesn't resemble a textbook. In the real world, businesses react to broader economic and demand growth (or shrinkage). Having more workers doesn't goose productivity or growth-if anything, productivity drops as more folks are employed.

Here's how it works. During recessions, businesses cut back as much as they can to stay afloat-they cut headcount, chop production, take factories offline, you name it. That forces them to do more with less as the cycle turns and demand rebounds-that's where productivity gains come from. They produce what they can with what they have, doing their best to meet demand while keeping costs in check. Once they squeeze out all the productivity gains they can-when they can no longer keep up with demand based on current staffing and production capacity-they staff up, upgrade equipment, reopen closed facilities and expand operations. Productivity drops as they add more capacity-they're no longer doing more with less. But then the new system gets more efficient, productivity improves some, and then they invest more and add headcount as needed. This continues until they overshoot and the cycle turns again. Every step of the way, hiring lags growth. That is the way of the world, folks.

So why is everything moving more slowly this time? Well, that's a matter of opinion! But my opinion, based on all the data I've seen, is that the Fed did it.^[iii] As your friendly MarketMinder whippersnappers wrote here, here and here, the Fed's quantitative easing (QE) squashed the yield curve, shrinking the gap between short and long rates and making lending less profitable-and less plentiful. It's no coincidence the weakest loan growth in decades occurred alongside the weakest expansion in modern history. Over a century's worth of data show steep yields and higher money supply growth are the ticket to swift growth, and lending is how broad money supply grows. During QE, it shrank for a long stretch.

Now QE is over, lending is up, and broad money (M4) is growing. That coincided with faster growth and higher business investment over the past year. Yes, growth slowed in Q4, but that isn't really something you can fix with policy-or something that even needs fixing. Fewer imports, more government spending and faster restocking would do it. But government spending isn't always a plus. Fewer imports would imply weakening demand. So, too, could faster restocking, if it meant goods piled up faster than businesses could sell them. That would point to an oversupply and a need to cut back later, which would trigger a fall in production and investment. That's the opposite of growth.

Far be it from us to defend any government policy-not our role. But overall, the data suggest America's private sector really isn't a "caged eagle ready to soar if released from the captivity of bad government policy." Private-sector components of GDP (household spending and private investment) have grown fine and accelerated in Q4, which doesn't seem like a problem needing fixing. To the extent there was a cage, the Fed created it, and the door opened last year. At some point, soon, that should become more apparent in headline data, lifting sentiment. Until then, patience-and don't despair, because markets will continue pricing all this in well before the rest of the world gets hip.

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